I received considerable feedback from last week’s publication (see How to outperform by 50-250% over 2-3 years), mostly related to gold and energy stocks.
In last week’s analysis, I had lumped these groups in with other cyclicals. Examining them further, I conclude that both gold and energy stocks have bright futures over the next 2–3 years. I estimate that gold prices could beat US large-cap growth stocks by about 100% over this period, and I would favor bullion over gold stocks. The upside target for energy stocks is a little bit tricky owing to their declining fundamentals and falling demand from ESG investing. The upside relative performance target is wider at 25–300% for this sector.
A New Commodity Supercycle
Both gold and oil are major commodities, and we may be seeing the start of a new commodity bull and supercycle for the next 10 years.
Commodity prices are very washed-out relative to stock prices. There is little or no institutional memory of what to do if inflation heats up. The last secular commodity bull began in the 1970’s, and there are hardly any portfolio managers working today who remember that era, and how to respond and position portfolios.
Here’s why investors should expect below-average returns over the next decade: the historical data exhibit a strong reversal tendency. To show this, I calculated a statistic known as the correlation coefficient, which would be 1.0 if the best trailing decade returns were correlated with the best subsequent decade returns, and so on down the line. The coefficient would have been minus 1.0 if the best trailing returns were correlated with the worst subsequent returns, and so on, while a coefficient of zero would mean there is no detectable relationship between the two.
When focusing on all months since 1881 in Shiller’s database, I calculated this coefficient to be minus 0.35, which is strongly significant at the 95% confidence level that statisticians often use when assessing whether a pattern is genuine.
At a minimum, it would be no surprise to see commodity prices rise as the global economic recovery gains strength as the COVID pandemic fades.
China has been a voracious consumer of commodities and the locomotive of global growth. Its November Caixin PMI, which measures the activity of smaller firms, has roared ahead to a decade high. This is supportive of a surge in commodity demand from the Middle Kingdom.
That brings us to the story of gold, which is traditionally viewed as an inflation hedge. Today, a combination of easy central bank policy determined to raise inflation and easy to neutral fiscal policy is likely to ignite a round of asset price inflation.
Indeed, inflationary expectations as measured by the 5×5 forward rate are rising. In response, the trade-weighted dollar (inverted scale) is falling. While inflationary expectations are still relatively tame at 1.9%, these readings nevertheless are signaling a rising inflation regime.
I expect that commodity prices will outpace the S&P 500 in the next few years. The chart below depicts gold prices, the CRB Index, and the ratios of the S&P 500 to gold and to the CRB. In particular, the S&P 500 to gold ratio is an especially sensitive barometer of commodity price strength. The bottom panel shows that we are undergoing a period of falling S&P 500/gold, which is reminiscent of the mid-1990’s and the post-GFC period when the economy was in expansion and commodities outperformed stocks.
Asset managers are catching on to this new commodity reflation trend. The BoA Global Fund Manager Survey shows fund manager weights in commodities began rising just as the S&P 500 to gold ratio started falling. Commodity weights are not excessive, and they have more room to run should inflationary and growth expectations rise further.
From a technical perspective, gold prices staged an upside breakout from a multi-year base. They retreated below the breakout as a test. One hint of bullish strength comes from inflationary expectations, which broke out of a declining trend line.
Moreover, gold sentiment has fallen to bearish extremes to levels last seen when gold was $1200/oz.
An important caveat for Canadian investors
I would like to add an important caveat for Canadian Dollar denominated investors. Commodities are usually priced in USD, but the CADUSD exchange rate has been highly correlated with commodity prices. While CAD denominated investors should still profit during an era of rising commodities, they will face headwinds if their currency exposure is unhedged.
A similar warning applies to investors residing in other countries with high levels of commodity exports, such as Australia and New Zealand.
Oil and gas: The new tobacco
Turning to the energy sector, the fundamentals look terrible. A recent Bloomberg article blared that Peak Oil is upon us, but it’s a Peak Oil of a different sort. The old Peak Oil thesis relied on dwindling global supply and the inability of producers to meet demand. Today’s Peak Oil is all about falling demand.
British oil giant BP Plc in September made an extraordinary call: Humanity’s thirst for oil may never again return to prior levels. That would make 2019 the high-water mark in oil history.
BP wasn’t the only one sounding an alarm. While none of the prominent forecasters were quite as bearish, predictions for peak oil started popping up everywhere. Even OPEC, the unflappably bullish cartel of major oil exporters, suddenly acknowledged an end in sight—albeit still two decades away. Taken together these forecasts mark an emerging view that this year’s drop in oil demand isn’t just another crash-and-grow event as seen throughout history. Covid-19 has accelerated long-term trends that are transforming where our energy comes from. Some of those changes will be permanent.
Exxon Mobil Corp. is about to incur the biggest writedown in its modern history as the giant U.S. oil and gas producer reels from this year’s collapse in energy prices.
Exxon — traditionally far more reluctant to cut the book value of its business than other oil majors — on Monday disclosed it will write down North and South American natural gas fields by $17 billion to $20 billion. That could make it the industry’s steepest impairment since BP Plc’s 2010 Gulf of Mexico oil spill that killed 11 workers and fouled the sea for months. Meanwhile, capital spending will be drastically reduced through 2025.
Estimating upside potential